Thursday, October 2, 2008

S&P 500 Index Sets New Volatility Record for Fourth Consecutive Day

When measuring volatility, there is a tendency to focus on historical volatility and implied volatility as the appropriate yardsticks. One looks backward and is a statistical calculation; the other looks forward and lets market participants estimate future volatility.

The VIX gets the bulk of the press, but as a measure of implied volatility, it tells you nothing about what has just happened.

Don Fishback and Adam Warner (Daily Options Report) have opined that historical volatility can be as useful in measuring volatility as implied volatility.

Depending on one’s purpose, I am inclined to agree. In fact, in addition to implied volatility and historical volatility (which is simply the standard deviation of the log of returns of a period of X days), I am a big fan of Average True Range, which is also known simply as ATR.

Developed by J. Welles Wilder and first made public in the classic New Concepts in Technical Trading Systems, ATR first calculates true range as the maximum of:

  1. the difference between today’s high and low;
  2. the difference between today’s high and the previous close;
  3. the difference between today’s low and the previous close.

Average true range is simply the true range averaged over a standard lookback period (most often 14 days), traditionally using an exponential moving average, but sometimes using a simple moving average.

Now for the punch line, which is probably a couple of paragraphs too late: in each of the past four days, the S&P 500 index (SPX) has set new all-time highs in its 30 day historical volatility reading, as well as the simple moving average version of ATR. Further, if you normalize ATR by dividing it by the daily close of the SPX, the past four days have also seen new all-time highs in the normalized ATR.

So…the VIX may be pulling back a little, but backward looking measures of volatility such as historical volatility and ATR are continuing to establish new all-time highs.

Further reading:

7 comments:

Anonymous said...

Hi Bill,

Thanks for the great blog!

This is a general Q, do you have on your site a list of good books to read re options? If not, could you give me a few names to start with?

Thanks again for all the great work you do here!

t.

Bill Luby said...

Hi anon,

You know, I don't have a list, but I should probably add one soon.

The two books I always recommend are Larry McMillan's encyclopedic Options as a Strategic Investment and Sheldon Natenberg's Option Volatility & Pricing. There are probably intermediate and intermediate to advanced level books, respectively.

A good options book for beginners may be more of a matter of personal taste. Guy Cohen's Options Made Easy should probably be on the short list.

Readers, what additions do you have?

Jared said...

Hi Bill & Anon,

We have a reading list available at http://www.condoroptions.com/index.php/recommended-reading/

I'd second the Natenberg pick for any intermediate readers.

Anonymous said...

Thanks, Bill and Jared. I appreciate it.

David said...

Thanks from me too re: the books.

And Bill I love this blog. So many other blogs seem to be cross-postings of Bloomberg articles with some commentary (ok, that's a little unfair).

You always seem to explore a different angle within your VIX-ish realm. Thanks again.

Pankaj said...

Bill,

Did you notice that the Put Options on VIX dont move as much as the VIX moves .. i.e., the implied volatility of the VIX is rising and rising.. How do you trade the downfall of VIX once the market starts rallying for the near term?

Cheers...
Pankaj

Bill Luby said...

Hi Pankaj,

The underlying for VIX options is the VIX futures, so to the extent that the options follow anything closely, they track the futures better than the cash/spot VIX.

Regarding the puts (and the calls), the mean reversion tendency of the VIX (and the VIX futures) means that these tend to move much more slowly than the cash/spot VIX.

If you are looking to trade VIX options with a bearish bias and are concerned about the high IV in the puts (and their sluggish movement), you might want to look at a bear call spread, where your theta (time decay) exposure is limited.

Cheers and good trading,

-Bill

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